The big news from this morning’s call was that J&J will “explore strategic options” for its Diabetes Care segment (LifeScan, Animas, Calibra), including operating partnerships, joint ventures or strategic alliances, or a sale of the businesses. While overall, this news cannot be completely surprising to anyone watching this market closely, it is disappointing in that it is such a clear sign of waning commitment to patients. We imagine pricing pressures in BGM driven by Medicare (and then other payers) contributed most to the decline, followed by, more recently, CGM becoming standard of care over BGM for highest-profitability patients. A more competitive insulin pump landscape has also been challenging. We speculate on potential partners and M&A below.

On the pharma side, revenue from the SGLT-2 Invokana (canagliflozin) franchise totaled $317 million in 4Q16, representing flat YOY growth, and $1.4 billion for the full year 2016, representing 8% YOY growth from $1.3 billion in 2015. Despite these lower-than-expected sales, we believe the SGLT-2 inhibitor will ultimately be a growth driver within J&J’s overall diabetes portfolio (spanning devices and pharmacotherapy) – though, of course, drug pricing in the US continues to be a major question. Still, a billion-dollar Invokana business is more profitable than a billion dollars of blood glucose revenue.

Reflecting ongoing weakness in the business, global LifeScan/Animas sales in 4Q16 fell to $462 million, down 4% year-over-year (YOY) as reported and 3% operationally. This marks 18 of the past 19 quarters with global sales declines. US sales fell 5% ($191 million), while the OUS business fared slightly better, down 1% operationally ($271 million). For 2016, global sales totaled $1.8 billion, down 7% as reported and 6% operationally against easy comparisons. Sales have fallen ~34% since the business peaked five years ago and profitability far more (though this is not reported).

There were no device pipeline updates on the call. Although CEO Mr. Alex Gorsky stressed multiple times throughout the call the $9 billion that J&J invested in R&D last year, it seems fairly obvious that diabetes devices have not been an R&D priority. The OneTouch Vibe Plus pump with Dexcom G5 integration was approved in the US and Canada in December; there is no launch timing, which is also unsurprising given that we don’t even know what is happening with this business. The WellDoc BlueStar/Verio BGM integration is expected to launch this quarter (1Q16) and we expect this will be on track since there are such high hopes for this partnership and since this has high potential to drive perceived and real value. The bolus-only OneTouch Via (Calibra) was most recently pushed back to a focused US launch in 1H17. We assume the automated insulin delivery US pivotal study is still being planned, with a launch most recently slated for late 2018/early 2019. We certainly hope to see both move forward, given the high potential for people with diabetes who are not doing well.

J&J provided its 4Q16 financial update this morning in a call led by CEO Mr. Alex Gorsky. In the morning’s biggest news, the company will be exploring strategic alternatives (defined as “operating partnerships, joint ventures or strategic alliances, or a sale of the businesses”) for its medical device Diabetes Care businesses – LifeScan, Animas, and Calibra. Profitability pressures (thanks Medicare) have challenged the field enormously, and have prompted so many problems for patients. This full report also covers major highlights on SGLT-2 inhibitor Invokana (canagliflozin) and fixed-dose combination Invokamet (canagliflozin/metformin). Plus, we have pipeline updates for you spanning therapy and devices.

Big picture, we’re disappointed in J&J as a company regarding this announcement; for so many years, J&J has made a big deal about its commitment to this field, and we would rather have seen J&J management show some grit and try to make the field better than just exit within a few years of things getting touch. We have never understood the management structure of diabetes devices at J&J, with diabetes device P&L going to the medical device business but the reporting structure up through consumer, so perhaps it is not entirely surprising. (As we wrote in 2014, “this is a very unusual set-up and don’t think from a motivational perspective that it’s advantageous for either Consumer or the medical device segment …”) It was extremely disheartening throughout the call to hear how committed J&J is to the entire field of diabetes through its work in “bariatric surgery and Invokana” (we were surprised that Investor Relations didn’t put Invokana first! Bariatric surgery helps many people but it’s not a population approach and it’s barely ever been mentioned in J&J calls for the 15 years that we’ve been covering the company …).

Long story short, 4Q16 was a challenging quarter for J&J Diabetes on the device sides as well as the pharmacotherapy side. See below for our top takeaways on 4Q16 and the full year 2016. You can view the company’s presentation slides here.

LifeScan/Animas Business Highlights

1. The slide deck noted that J&J is “seeking strategic options for Diabetes” (LifeScan, Animas, and Calibra Medical), including forming operating partnerships, joint ventures or strategic alliances, a sale of the businesses, or other alternatives. Mr. Gorsky emphasized that there is no definitive timeline for this evaluation and there is no guarantee that there will be any transaction. However, the fact that J&J announced this reflects the struggling BGM and insulin pump businesses facing tremendous competition and pricing pressures – and, undoubtedly, that momentum is gaining in CGM, and J&J doesn’t have its own CGM business. We speculate below on the potential impact to J&J’s diabetes device partners (Dexcom, WellDoc) and share our views on the likelihood of different device players acquiring the business(es). Who will invest in these businesses?

2. Back on the reporting front, global LifeScan/Animas revenue totaled $462 million in 4Q16, down 4% as reported and 3% operationally year-over-year (YOY) on an easy comparison to 4Q15. $462 million is the third lowest quarterly sales in our LifeScan/Animas model, which goes back more than a decade. Of more concern, 4Q16 now marks 18 of the past 19 quarters with global sales declines. For 2016, worldwide sales totaled $1.8 billion, down 7% as reported and 6% operationally against an easy comparison. Sales have fallen ~34% since the business peaked five years ago.

3. US Diabetes Care sales totaled $191 million in 4Q16, falling 5% YOY against an easy comparison (sales fell 2% YOY in 4Q15). The quarterly performance ties last quarter for the third lowest US revenue ever recorded in our J&J model. In 2016, US sales declined 11% YOY to reach just $739 million. This is the first time our model has seen either the US or international annual business fall below $830 million – and the US dipped nearly $100 million below that.

4. International Diabetes Care revenue totaled $271 million in 4Q16, down 1% operationally YOY. The comparison was on the difficult side, relatively speaking, to 5% operational growth in4Q15. Still, nine out of the past ten quarters have seen negative reported growth in the International Diabetes Care business. International sales for 2016 fell 2% operationally to reach $1.1 billion. This marks the lowest annual international revenue since 2006 ($940 million).

LifeScan/Animas Pipeline Highlights

5. In December, FDA and Health Canada approved J&J’s OneTouch Vibe Plus insulin pump with Dexcom G5 integration. The company is “evaluating launch timing,” and given today’s commentary on the business, we’ll be interested to see if it might launch in 2017 – we certainly hope for the sake of patients that it will and that “shareholder value” won’t halt this. The CGM-integrated pump is approved down to age two, represents the first approved G5 pump integration, and will allow patients to view CGM data on either the Dexcom G5 app or pump. We do note that Medtronic’s activity last year to “own” the new BD set was a major blow to all insulin pump manufactures (that set is now on hold), creating an even more fragile ecosystem.

6. We learned in a December email exchange with J&J that its OneTouch Via (formerly Calibra Finesse) bolus-only insulin delivery patch device will undergo a “focused” US launch in 1H17. This is back from guidance at ADA 2016 that called for a launch in select markets outside the US by late 4Q16, followed by a US launch in early 2017. The device was resubmitted to FDA in November for new 510(k) clearance of an updated manufacturing process. This device has major potential to help patients with diabetes on the adherence front (which could raise all tides) – we certainly hope this very exciting product that could help the very challenging insulin delivery environment in the MDI arena won’t be delayed.

7. Animas’ automated insulin delivery plans were not mentioned – we last heard (via email on November 30) that the company is still working with the FDA to plan a pivotal trial, and a launch is expected in late 2018/early 2019, pending what happens next with this business.

8. There was no mention of the WellDoc BlueStar integration partnership (including a J&J investment), which received FDA clearance in December and has been slated to launch in 1Q17. With Calibra, this business also has very high potential in our view.

Janssen Highlights

9. Sales of SGLT-2 inhibitor Invokana (canagliflozin) and fixed-dose combination Invokamet (canagliflozin/metformin) were flat year-over-year (YOY) operationally and as reported at $371 million in 4Q16. Full year 2016 revenue for the Invokana franchise totaled $1.4 billion, up 8% YOY from $1.3 billion in 2015. Management characterized Invokana’s 4Q16 as a quarter of “modest US decline” balanced out by continued ex-US growth. US revenue fell 4% YOY in 4Q16 to $334 million while ex-US revenue grew 54% YOY to $37 million (both as reported and operationally), though this still marks Invokana’s lowest YOY ex-US growth in 2016. Despite this relatively weak performance overall, management cited Invokana as a key product indicative of the company’s commitment to diabetes as a therapeutic area.

10. J&J’s presentation slides mentioned that Invokana has now captured 6.1% of all type 2 diabetes prescriptions in the US, down slightly from 6.3% in 2Q16. We wonder how much the franchise is feeling pressure from positive EMPA-REG OUTCOME results for Lilly/BI’s SGLT-2 inhibitor Jardiance (empagliflozin) as well as the expanded Jardiance indication to include reduction of cardiovascular (CV) death – of course this label update occurred very late in 4Q16, so its effect on competition within the SGLT-2 inhibitor class is more so something to watch for in 2017 (though we believe many HCPs knew about it and it impacted their decisions). Invokana’s cardiovascular outcomes trial (CVOT) CANVAS is slated to report full results at ADA 2017. While there was no discussion of the CVOT (or of renal outcomes trial CANVAS-R) during today’s prepared remarks, management was quite optimistic during J&J’s 3Q16 earnings call that CANVAS will report “very similar” positive results to EMPA-REG OUTCOME.

11. Management announced that the company’s first US Pharmaceuticals Transparency Report will be released in 1Q17 – a first step toward “demonstrating how serious we are on responsible drug pricing.” The report will include information on J&J’s approach to pricing and further details on support programs for patient access to Janssen’s pharmaceutical products. The competitive environment around drug pricing, particularly in diabetes, was a major theme during today’s Q&A discussion – in response to concerns and criticisms, management emphasized that J&J invests more in R&D than in sales/marketing, and that the $9 billion invested in R&D for the full year 2016 (we wonder, how much of this went to innovation in diabetes beyond the outcomes trials?) was more than what the business brought in through net US price increases.

12. Fresh off a meeting with President Trump (which took place yesterday), Mr. Gorsky outlined four key components that J&J management hopes to see in new healthcare legislation to replace the Affordable Care Act (ACA): (i) retained elements from the ACA including coverage of preexisting conditions and coverage for young people on their parents’ plans (how that would be paid for wasn’t addressed); (ii) supports for a competitive market health insurance marketplace (same); (iii) a move toward value-based care and reimbursement; and (iv) reforms that prioritize preventative care and wellness (this was terrific to hear though we don’t see a lot of investment from J&J on these fronts to date). The company experienced no uptick in business – pharmaceutical or otherwise – upon implementation of the ACA, according to Mr. Gorsky, so he expressed no concern about the negative consequences of its repeal. This was, again, disappointing, given the potential negative impact on such a wide range of patients.

LifeScan/Animas Highlights

The slide deck noted that J&J is “seeking strategic options for Diabetes” (LifeScan, Animas, and Calibra Medical), including forming operating partnerships, joint ventures or strategic alliances, a sale of the businesses, or other alternatives. Mr. Gorsky emphasized that there is no definitive timeline for this evaluation and there is no guarantee that there will be any transaction (the presumption seemed to be that everyone would want some sort of transaction), but the fact that J&J is moving forward with this and announced it reflects the struggling BGM and insulin pump business facing tremendous competition and pricing pressures as well as the movement to CGM from BGM for the most profitable patients (high frequency testers). Without offering specific numbers, CFO Mr. Dominic Caruso acknowledged that, unsurprisingly, profitability has declined. We expected this, of course, with Medicare (and other payer) pricing pressure in the US, but J&J has never announced specifics on profitability. This discussion is not foreign to a company the size of J&J, which divested eight businesses from its portfolio in 2016 alone. Mr. Gorsky repeatedly highlighted that the company is still committed to diabetes, including the Janssen Invokana franchise and bariatric surgery, and also repeatedly thanked the devices team from diabetes, which was very apt given so much strength from a number of very talented managers and teams.

Worldwide VP of Insulin Delivery Mr. Wilson stated in a conversation with us this afternoon that in this period of strategic exploration, nothing changes in the way J&J is manufacturing and delivering products. He specifically confirmed that the OneTouch Via still has an intended 1H17 focused US launch, which was great to hear – patients have been waiting for this product for a long time and we believe there is enormous upside here to help improve delivery of insulin, one of the world’s most dangerous drugs.

On one hand, each of J&J’s device businesses has several strengths and potential to turn around, given the right focus and investment. LifeScan is a long trusted BGM brand with tremendous global scale and manufacturing, in-house expertise, upside with the WellDoc integration, and continued volume growth (see below). Animas has the first Dexcom G5 integration approved, a years-in-the-making pipeline to automate insulin delivery, and well over 100,000 users (One Touch Ping has 114,000+ users alone, per 3Q16). Last and perhaps most exciting, Calibra Medical has the long-awaited OneTouch Via bolus-only insulin delivery device, which is now slated for a focused launch in the US in 1H17. These are incredibly valuable assets that could be leveraged and improved and help many people with diabetes dose insulin more safely, optimize medication, and get better feedback on their food, exercise, and diabetes care. In going through the exercise below, we believe all three segments are potential acquisition targets and it will be interesting to see if they are positioned only as a bundle or separately.

On the other hand, there are some important headwinds for all three businesses. BGM has a very negative growth trend that does not seem to be abating, particularly with downward pricing pressure driven by Medicare – this has been incredibly short-sited in our view. Broader use of sensors by patients who have made the highest profits for LifeScan are also a concern (see below), and although top manufacturer Dexcom is a partner, J&J doesn’t own any CGM assets. The pump landscape has never been more competitive, and Animas has moved slowly toward automation and a modern user experience. Meanwhile, One Touch Via (Calibra’s Finesse) has taken years to come to market and will soon see competition from new and existing type 2-focused insulin delivery devices (BD, CeQur, Insulet, and Valeritas). Some also argue that OneTouch Via could net increase costs for payers, since MDIs will need the device, rapid-acting insulin, AND basal insulin – naysayers may be proven wrong once outcomes are available from the ongoing study in type 2s (finishing this fall). We strongly believe that the Via has high potential to improve long-term outcomes though this data must be developed.

J&J seems to be acknowledging, with this move, that CGM is becoming standard of care. Abbott, Dexcom, and Medtronic are all contributing to this, at least in type 1s and previous high-frequency testers. Dexcom’s non-adjunctive indication (US, EU), combined with Abbott’s factory-calibrated FreeStyle Libre, definitely reduce the need for users to check blood glucose frequently with a BGM. Meanwhile, Medtronic’s more accurate upcoming Guardian Sensor 3 is much better and we expect that on average, it may also reduce SMBG use for 670G or Guardian Mobile users in the US (once launched). Plus, we expect to see CGM move into a broader population beyond pumpers in the coming years. Dexcom’s new patients are now ~60% from MDI, and today alone, two major RCTs were published in JAMA showing the benefits of CGM in MDI users: Dexcom’s DIaMonD study and the GOLD study in Sweden. This is a very big deal for the field and for Dexcom, given how payers are likely to view this (positively). Plus, with professional CGM products like Abbott’s FreeStyle Libre Pro and Medtronic’s greater focus with Qualcomm and Henry Schein, we wonder if type 2s checking 1-2 times per day might get more value from professional CGM a few times per year. Of course, Abbott and Dexcom/Verily also plan to drive real-time sensor penetration into type 2 with their easier-to-use, less expensive devices. Overall, it’s important to note that CGM is still highly underpenetrated even in high-frequency users, so BGM will be here to stay for some years; still, the headwinds will not be easy in the next 5-10 years and the patients that do stay on BGM are likely to be far less profitable patients compared to those leaving CGM that used 6-8 strips a day or more.

What is the Impact on Current J&J LifeScan/Animas Partners?

Potential Impact?

Our Rationale

Dexcom

Neutral

~60% of Dexcom’s new patients are now coming from MDI, and the partnership with Animas to automate insulin delivery has moved slowly – while Animas is probably not critical for Dexcom’s growth, if anything, another manufacturer may be able to manage Animas better with greater financial investment (we don’t think it got support from the highest management levels though this is admittedly hard to assess). Dexcom could certainly focus resources on other areas (type 2, MDI, decision support, payers) and partners (Verily, Tandem, Bigfoot, Beta Bionics, etc.). We have no idea how much time Dexcom is devoting to this partnership, but we assume it is not zero. We do believe from an investor perspective, this move indicates J&J’s management believe that diabetes glucose management standard of care has begun to change from BGM to CGM for patients with the greatest access.

WellDoc

Neutral short-term, potentially negative long term?

The J&J partnership is very key for WellDoc’s BlueStar to achieve nationwide scale. If J&J’s moves away from BGM, it could be a negative for this partnership long term. We can’t imagine this news will impact the 1Q17 planned launch, simply because any deal would require some time to execute. As well, given that WellDoc could be a driver of better diabetes management for patients using LifeScan strips, we imagine that J&J may well actually invest even more in this partnership during this period.

Abbott is focused on FreeStyle Libre, and given the success, we expect less focus on the core BGM mid/long-term. We do not imagine a move into insulin delivery fits within Abbott’s strategy, especially because the Florence pump was never broadly commercialized. That said, we can imagine the Via and the Libre consumer product being an incredible combination!

Ascensia (Panasonic Healthcare Holdings)

Possible?

Panasonic Healthcare Holdings (which is 80% KKR) acquired Bayer Diabetes Care’s BGM business (now Ascensia) for about $1.0 billion last year, and acquiring LifeScan would certainly further increase scale and profitability, depending how the businesses might work together. Via would be attractive. Is the sum of Ascensia + LifeScan greater than the companies operating separately? (Could they even be combined?)

BD

Possible?

The OneTouch Via (formerly Calibra Finesse) would fit with BD’s core competencies in insulin delivery and could complement very well the upcoming type 2 patch pump. An Animas acquisition would allow BD to further move into insulin pump delivery, building on the MiniMed Pro-set and upcoming type 2 patch pump and gaining real brainpower. Still, BD may choose to stay focused on needles and its own devices. Overall, a LifeScan acquisition seems extremely unlikely, as BD exited the BGM business years ago.

Dexcom

Unlikely?

An Animas acquisition would be a long shot, though Dexcom could benefit from owning its own pump to commercialize an automated insulin delivery system. On the other hand, this would probably jeopardize its other insulin delivery partnerships, so the net effect might be negative. Plus, CEO Kevin Sayer and former CEO Terry Gregg have repeatedly expressed no desire to get back into the pump business following their time at MiniMed. Given Dexcom’s goal to replace fingersticks, a LifeScan acquisition would not seem to be a fit.

Insulet

Unlikely?

Insulet’s core DNA is in tubeless insulin delivery with the OmniPod, and the company recently divested the very slow-growing Neighborhood Diabetes business. We see low odds of an acquisition here, though the OneTouch Via (Calibra Finesse) would very nicely complement the OmniPod – particularly given Insulet’s core expertise in patch device manufacturing.

Medtronic

Possible?

Animas would add further scale to Medtronic’s core MiniMed pump business, while Calibra could expand on Medtronic’s move into type 2 diabetes and the existing i-Port Advance product for injectors. Acquiring the LifeScan business could expand Medtronic’s broader focus on glucose monitoring with CGM, or perhaps drive new service models with connected BGMs though after many years of partnership with LifeScan, Medtronic partnered with Bayer.

Perrigo

Possible?

Could Perrigo acquire the LifeScan business and turn it into a store brand juggernaut? This seems like a really interesting idea for them.

Roche

Possible?

The LifeScan and Animas business would increase the scale of Roche’s Accu-Chek BGM and pump businesses – like Ascensia, perhaps there is synergy to be gained with the combination. On the other hand, Roche seems to be doubling down on CGM and will no longer sell new pumps in the US. But, again, Via would be a strong asset for them, as would the WellDoc partnership.

Verily

Possible?

Verily excels at software and could bring some of the Google magic to Animas’ increasingly outdated hardware. Such a transaction could also give the Sanofi and Dexcom partnerships more momentum, or give Verily assets to drive change in diabetes on its own. OnDuo could move in likely quite inexpensively.

What about a partnership/joint venture? This seems less likely, and more apt to be just corporate jargon, but we could imagine several approaches to a partnership or JV, assuming there is (i) mutual alignment and synergy – what is to be gained on both sides?; (ii) focus on improved access, cost, and affordability; (iii) novel diabetes care delivery models or services; and/or (iv) opening new markets, particularly in the developing world, where so much more focus on diabetes is needed. There are already many BGM and insulin delivery companies out there selling hardware, so a two-company partnership could add further decision making complexity in a healthcare environment that increasingly demands launching, learning, and iterating quickly. One option is for J&J and a partner to tap into the global population of people with diabetes who have little to no access to strips or care (let alone a CGM or pump) – what could be done with the existing J&J assets for this group of individuals? How could J&J drive 80% of the value of expensive systems with 20% of the costs? What an idea! The diabetes community would certainly rally around this though Mr. Gorsky’s words about focusing on “shareholder value” might make this very challenging. Still, what commitment to diabetes this would show! Given that the price for the business might be very low, perhaps a public / private partnership could be put together. A dream at best, we imagine.

These are challenging times for some pump and BGM manufacturers – will others consider partnering/divesting? Roche recently halted new pump sales in the US and BGM continues to see pressure (though Roche and Abbott have yet to report this quarter; both have of course invested in continuous sensors). Automated insulin delivery definitely offers upside for pump manufacturers, though likely adoption isn’t clear and value will absolutely need to be demonstrated. Ironically, this is more than possible with CGM and time-in-zone, though time-in-zone still needs to be proven in reducing long-term outcomes. We’d love to see all of industry along with NIH invest in such a study.

Global LifeScan/Animas sales saw continued challenges. Sales were $462 million in 4Q16, declining 4% as reported and 3% operationally year-over-year (YOY) on an easy comparison to 4Q15. $462 million is the third lowest quarterly revenue recorded in our LifeScan/Animas model, which goes back to 2o05 (the only lower totals were 1Q16 and 3Q16). Of more concern, 4Q16 now marks 18 of the past 19 quarters with global sales declines (3Q14 was the lone exception and that was an easy comparison). Sequential sales grew 8% against a decade-low $427 million in 3Q16.

For 2016, worldwide sales totaled $1.8 billion, down 7% as reported and 6% operationally; this was against an easy comparison to a 10% reported decline in 2015. The figure below captures just how tough the devices business has been for J&J since the onset of competitive bidding: from the all-time full-year sales high of $2.7 billion just five years ago, 2016 sales were down ~34%. On the other hand, the business is arguably stabilizing relative to the declines seen in 2012-2014.

Figure 1: Global, Us, International Quarterly Sales (1Q12-4Q16)

Figure 2: Global, US, International Full-Year Sales (2007-2016)

3. US LifeScan-Animas Sales Fall 5% in 4Q16, 11% in 2016

US Diabetes Care sales totaled $191 million in 4Q16, falling 5% YOY as reported against an easy comparison (sales fell 2% YOY in 4Q15). The quarterly performance ties last quarter for the third lowest US revenue ever recorded in our J&J model – only outperforming revenue from 1Q16 ($180 million) and 2Q16 ($177 million) – and the fifth-ever quarterly revenue to dip below $200 million. For context, US LifeScan/Animas sales peaked at $362 million in 4Q07, nearly double 4Q16’s sales – a testament to the impact of competitive bidding and other headwinds in BGM.

For the full year, US sales declined 11% YOY to reach just $739 million, despite an easy comparison to 2015 when sales fell 4%. This is the first time in our model, which goes back to 2005, where J&J has seen either the US or international LifeScan/Animas business fall below $830 million – and it dipped nearly $100 million below that. No single quarter in the past year broke the $200 million mark.

Unsurprisingly, the slide deck noted that US BGM sales were impacted by “negative price and rebates offset by higher strip consumption” – that implies volume growth remains strong, even as pricing declines. US revenue declined 5% YOY, and we have to assume profitability is falling at that rate or higher. On the insulin delivery side, sales were “lower” due to competitive pressures – no surprise there, given the fall launches of Medtronic’s MiniMed 630G and Tandem’s t:slim X2, strong momentum for Insulet, and the upcoming MiniMed 670G launch in the Spring.

Abbott reports January 25 and Roche reports next week. Will they experience comparable US and international challenges? Abbott, of course, has Libre as some offset.

4. International LifeScan/Animas Sales Decline 1% Operationally in 4Q16, Down 2% in 2016

International Diabetes Care revenue totaled $271 million in 4Q16, down 3% as reported and 1% operationally YOY. The decline came against a fairly neutral comparison to 4Q15, when sales fell a significant 10% as reported, but grew 5% operationally. Still, nine out of the past ten quarters have seen negative reported growth in the International Diabetes Care business. Sequentially, sales outside of the US grew 15% against the lowest base ever recorded in our model ($236 million in 3Q16). The international Diabetes Care segment seems to follow a recurring pattern of sequential growth in Q2 and Q4, with declines in Q1 and Q3. However, this micro-trend comes against the backdrop of consistent negative YOY growth:

International sales in 2016 fell 4% as reported and 2% operationally to reach $1.1 billion, marking the lowest annual international revenue since 2006 ($940 million). This was despite a fairly easy comparison to 2015, when sales fell 14% as reported and grew 1% operationally.

The accompanying slide deck notes that BGM sales outside of the US suffered from Algerian import restrictions and insulin delivery experienced softness in consumables. The consumables softness is odd – while we were expecting this result from the new Medtronic /BD set, delays with that product make it unlikely that this is the reason for the weakness. We wonder what else is driving that, unless patients are now getting sets through a different source outside the US or are switching to different pumps – distributors may be buying fewer sets from Animas.

LifeScan/Animas Pipeline Highlights

5. No Update on OneTouch Vibe Plus/Dexcom G5 Launch; Approved in US, Canada in December

In December, FDA and Health Canada approved J&J’s OneTouch Vibe Plus insulin pump with Dexcom G5 integration.The company is “evaluating launch timing,” and given today’s commentary on the business, we’ll be interested to see if this launches this year. The CGM-integrated pump is approved down to age two, represents the first approved G5 pump integration, and will allow patients to view CGM data on either the Dexcom G5 app or pump screen. We’re not sure if J&J has its own smartphone app, or if the Dexcom app will show insulin on board from the pump. OneTouch Vibe Plus will now have Bluetooth built in (to communicate with G5), which could potentially allow for remote upgrade capabilities; we’re not positive about the latter, since Tandem’s Device Updater is a web interface and required a separate submission. We learned in a conversation with J&J that this product was submitted to FDA in June – that reflects a ~ six to seven month review, or three times faster than the Vibe with G4’s ~20 month review – and closer to the impressive three-month review for the 670G. This pump is an important update for J&J, who brings its CGM integration up to speed with Dexcom’s latest transmitter, builds Bluetooth into the pump, could possibly beat Tandem’s t:slim X2 with G5 integration to market (FDA submission was expected by the end of 2016), and completes a key stepping stone on the way to the hypoglycemia-hyperglycemia minimizer. Last we heard, the pivotal was under discussion with FDA; launch expected in late 2018-early 2019. We are disappointed to see the OneTouch Vibe Plus’ user interface has not been updated much from the previous Vibe, which does put Animas well behind Tandem’s t:slim X2 and Insulet’s upcoming OmniPod Dash on this front; for some, this is the “cool factor”.

6. OneTouch Via Focused US Launch in 1H17; New Manufacturing Process Re-Submitted in November

We learned in a December email exchange with J&J that its OneTouch Via (formerly called the Calibra Finesse) bolus-only insulin delivery patch device is expected to undergo a “focused” US launch in 1H17. This is back from guidance at ADA 2016 that called for a launch in select markets outside the US by late 4Q16, followed by a US launch in early 2017. The device was resubmitted to FDA in November for new 510(k) clearance of an updated manufacturing process. While still relatively on pace for US launch, work to automate the production process and scale manufacturing capabilities has presumably pushed international timing back. We are not sure how broad the “focused” launch will be, but we expect a limited roll out to learn from early adopters, make sure manufacturing and access is in place, etc. BD/Medtronic’s MiniMed Pro-set certainly benefitted significantly from a limited US launch, which ultimately uncovered some issues with cannula kinking and training; see our coverage here. Adam and Kelly are eager to try OneTouch Via – the slim on-body form factor seems very appealing, particularly from patients who have otherwise refused to use prandial insulin.

According to the clinicaltrials.govpage, the OneTouch Via’s 24-week clinical trial (n=280) is ongoing and should complete by October 2017. The study randomizes type 2s not achieving glycemic target (A1c 7.5-10%) to either OneTouch Via or the Novo Nordisk FlexPen to initiate bolus insulin therapy. The primary endpoint is A1c at 24 weeks, with secondary endpoints including time-in-range and treatment satisfaction. This study should be a positive for reimbursement and marketing, though is not a gating factor to launch, as we understand it. We can’t wait to see the results of this trial – we imagine the insulin manufacturers would be interested also, now that the Via may be available to acquire.

Per the Medical Device Business Review, there are two OneTouch Via products in the pipeline: a smart version with connectivity and a version with a larger reservoir. These both seem like logical expansions to improve the convenience factor of the device. We understand that a one-unit bolus version is in development – this seems very smart, as many type 1s will be very interested though many would also like a half unit bolus version.

As a reminder, the OneTouch Via is a three-day, very slim profile (2 inches long, 1 inch wide, and 0.25 thick), bolus-only delivery device. J&J acquired the device from Calibra Medical in July 2012 and it secured initial FDA clearance way back in 2010 for type 1 and type 2 diabetes, though an updated manufacturing clearance is pending.

7. No Update on Animas Automated Insulin Delivery Pivotal; Launch Last Expected in late 2018-early 2019

Animas’ automated insulin delivery plans were not mentioned – we last heard (via email on November 30) that the company is still working with the FDA to plan a pivotal trial, and a launch is expected in late 2018/early 2019. The study was previously expected to begin in 4Q16 (per July’s Keystone conference), though that did not happen. Prior to the email update, Animas had positioned itself to be second to market in the US, though now its timeline is behind Medtronic, Tandem, Bigfoot, and Beta Bionics (of course, timelines are always in flux, for both big and small players). On the bright side, the approval of the “OneTouch Vibe Plus” pump with Dexcom G5 integration is a key step on the way to an automated product. The approval encompasses children as young as two years old, which puts Animas in good position to have a market advantage in pediatrics when it’s Hypoglycemia-Hyperglycemia Minimizer does hit the market. Medtronic’s MiniMed 670G pivotal only went down to 14 years, and Medtronic is currently enrolling for a pediatric study in 7-13 year olds that will wrap up in June, which it hopes will expand the FDA label for the 670G. The 670G is contraindicated in children under the age of seven due to the system’s design and daily insulin requirements. As a reminder, Medtronic pushed back the full launch timing of the 670G to May-October of this year, meaning a late 2018 launch for Animas (on the early side) could put it only a year behind Medtronic. First to market is an advantage in some respects though in others, learning from the first mover is also an advantage!

8. No Update on WellDoc BlueStar Integration; Previously Slated for 1Q17 US Launch

Neither prepared remarks nor Q&A mentioned the WellDoc BlueStar integration partnership (including a J&J investment), which received FDA clearance in December and is slated to launch in 1Q17. The system will integrate the BlueStar mobile app (Android, iOS) with LifeScan’s OneTouch Verio Flex BGM and paired Reveal app (Android, iOS), though use of the Reveal app will be optional. It’s still not clear what the business model will look like (e.g., traditional BGM vs. WellDoc’s prescribed-as-a-drug model vs. something else?), though talks are ongoing with payers, whom we would assume would be quite interested. We’re not sure if today’s comments on the Diabetes Care business impact this near-term launch, but we assume not. We did learn that there will be a prescription-only BlueStar app, as well as a non-prescription version (without an insulin calculator; also 1Q17 launch), each of which will wirelessly receive blood glucose values from the Verio Flex meter (via Bluetooth), saving users manual BG entry, a big deal.

Focused US launch in 1H17, international launch “will not occur in the near term” (December email correspondence). Resubmitted to the FDA on November 29 for new 510(k) clearance of an updated manufacturing process.

Animas Vibe System integrated with Dexcom G5 technology

Approved by FDA and Health Canada for children as young as 2 in December 2016; launch timing not shared.

Janssen Highlights

Sales of SGLT-2 inhibitor Invokana (canagliflozin) and fixed-dose combination Invokamet (canagliflozin/metformin) were flat year-over-year (YOY) operationally and as reported at $371 million in 4Q16. Management characterized Invokana’s 4Q16 as a quarter of “modest US decline” balanced out by continued ex-US growth. US revenue fell 4% YOY in 4Q16 to $334 million while ex-US revenue grew 54% YOY from a much lower base to $37 million (both as reported and operationally), though this still marks Invokana’s lowest YOY ex-US quarterly growth for 2016. Sequentially, sales rose 13% overall, 14% in the US, and 9% internationally, but notably this occurred against an easy comparison, as Invokana sales declined 14% sequentially in 3Q16. Despite this relatively weaker performance, management cited Invokana as a key product indicative of the company’s commitment to diabetes as a therapeutic area. In the context of a struggling Diabetes Care business over at LifeScan/Animas, we’re happy to note management’s continued commitment to growing the Invokana franchise; although it appears that sales of the product may be plateauing as competitive pressures in the SGLT-2 inhibitor field intensify, we believe will be temporary if there are positive outcomes trials. Notably, we look very forward to results from the CANVAS cardiovascular outcomes trial (CVOT) and the CANVAS-R renal outcomes trial to read out in mid-2017 (more on both of these below) –positive data would be a significant boost to Invokana’s sales and prescription volume in our view. Lilly/BI’s SGLT-2 inhibitor Jardiance (empagliflozin) recently garnered an expanded label indication for the reduction of cardiovascular death and we expect this new indication will catalyze growth in the SGLT-2 inhibitor class as a whole – but, especially for Jardiance, which is the only SGLT-2 at present with this very attractive (though admittedly confusing) indication. Jardiance data on the kidney front is also very attractive, of course, and represents another competitive headwind on Invokana. The SGLT-2 class as a whole grew enormously in 1H16 as well as 3Q16, and we expect increased patient and provider education on the cardiovascular effects of Jardiance will drive further upswing for the overall class, as the current expectation among some is that the cardioprotection is a class effect. Invokana in particular benefits from favorable formulary positioning due to its first-to-market status in the US, thus we imagine some patients and prescribers will choose Invokana based on ease of access compared to Jardiance.

Full year 2016 revenue for the Invokana franchise totaled $1.4 billion, up 8% YOY from $1.3 billion in 2015. Again, sales growth was more substantial in ex-US markets (up 91% YOY vs. 2015) compared to the US market (up 3% YOY vs. 2015) though of course this is from a far lower base. Overall, the full year results represent a clear leveling off of growth for the Invokana franchise – annual results in 2015 (the first year in which the franchise cleared blockbuster status) more than doubled from ~$500 million in 2014 and rose nearly 20-fold from ~$70 million in 2013. That said, the plateau in sales is not completely unexpected three-plus years after launch, especially given the high base and the ongoing safety warnings in late-2015 through 2016 and the less competitive overall profile given Jardiance’s cardiovascular and kidney outcome results in 2016.

Figure 3: Invokana Sales (1Q14-4Q16)

J&J’s presentation slides shared that Invokana has now captured 6.1% of all type 2 diabetes prescriptions in the US, down slightly from 6.3% in 2Q16 – by value as well as volume, the franchise’s market share was essentially flat in 4Q16. This raises interesting questions about how Invokana is faring against leading commercial competitors in the SGLT-2 inhibitor class, namely Lilly/BI’s Jardiance (empagliflozin) and AZ’s Farxiga (dapagliflozin), some of which we’ll be able to answer next week once Lilly reports its 4Q16 earnings on January 31, AZ on February 2. We expect Janssen’s franchise will face enhanced competitive pressure within the SGLT-2 inhibitor class in 2017 from the expanded Jardiance indication to include reduction of cardiovascular (CV) death based on the positive EMPA-REG OUTCOME. This label update occurred very late in 4Q16, and its effect will likely manifest in 2017 though undoubtedly, many HCPs were already guiding patients to Jardiance given this expected label change. Lilly/BI’s Synjardy (empagliflozin/metformin), Synjardy XR (empagliflozin/metformin extended-release), and Glyxambi (empagliflozin/linagliptin) also recently received FDA approval for label changes to include EMPA-REG OUTCOME data. While we expect the Jardiance franchise will continue to grow market share, we do also expect that the expanded indication will be a net positive and grow the SGLT-2 inhibitor class a whole as well – though there will be big questions on cardiovascular and kidney benefit until this is seen across the class. We do see Invokana as particularly well-positioned to take advantage of positive momentum for the class given its favorable formulary positioning in the US although this is hard to assess – it may also be that Invokana pricing remains a bit higher given Janssen likely expectation that the positive outcomes data will emerge. Importantly, Invokana’s cardiovascular outcomes trial (CVOT) CANVAS is slated to report full results at ADA 2017. While there was no discussion of the CVOT (or of renal outcomes trial CANVAS-R) during today’s prepared remarks, the company’s presentation slides did list CANVAS as a key upcoming event for its pharmaceutical portfolio. Indeed, as CV outcomes (and increasingly kidney outcomes) become more central to diabetes management, demonstrated cardioprotection will be crucial for the long-term commercial success of any new diabetes therapy, including SGLT-2 inhibitors. J&J management was quite optimistic during the company’s 3Q16 earnings call that CANVAS will report “very similar” positive results to EMPA-REG OUTCOME – this would clearly be a huge win for J&J and we look forward to the outcome come June.

There was no mention of the planned prediabetes CVOT for Invokana, first announced during J&J’s 3Q16 update, and one of the most exciting elements of the entire Invokana franchise in our view. The company first publicly expressed interest in a prediabetes indication for Invokana back in Spring 2015, through a Pharmaceutical Business Review, and it appears that the company has pivoted to specifically evaluating a cardiovascular indication in a prediabetes population. Wow! We certainly hope that this outcomes trial is still on the docket – prevention of CV complications is such an important aspect to treating type 2 diabetes, and we’d love to see these prevention efforts start as early as prediabetes. We’re curious about trial design, timing, and implications: Will the study necessitate a longer follow-up period to accumulate sufficient CV events in a slightly lower-risk population? When can we expect the study to begin enrollment? Will the trial include diabetes delay and prevention endpoints in addition to cardiovascular endpoints? If positive, how would J&J use this data to bolster its business around Invokana? Will J&J expand to positioning Invokana as a cardiovascular drug for people without diabetes? Is a cardiovascular indication a higher priority for J&J than a prediabetes indication (presumably yes, since there is not even pre-diabetes guidance, but we do not know)? For now, we can only speculate; we’re incredibly eager to learn more.

11. US Pharmaceuticals Transparency Report Promised by End of 1Q17

Management announced that the company’s first US Pharmaceuticals Transparency Report will be released in 1Q17 – a first step toward “demonstrating how serious we are on responsible drug pricing.” The report will include information on J&J’s approach to pricing and further details on support programs for patient access to Janssen’s pharmaceutical products. As the controversial issue of US drug pricing heightens further, we think more transparency from the pharmaceutical industry is absolutely key. We’re hopeful that pharma can work collaboratively with other stakeholders, including the major pharmacy benefits managers (PBMs), to address the all-too-high cost of drugs in diabetes and other disease areas (we also emphasize we hope PBMs can work with pharma). We’re also keen to hear more about the patient support programs, since “excess costs” to administer co-pay access programs were cited as a reason for Invokana’s dip in 3Q16 (we’re pretty sure this was an investor relations mistake). There was no explicit discussion of reimbursement during the 4Q16 call, but management has previously highlighted Invokana’s favorable formulary positioning – in 2Q16, the drug was ~70% preferred among commercial health insurance plans and was covered by ~90% of Medicare Part D plans. We look forward to reading the US Pharmaceuticals Transparency Report, and we’re glad to see meaningful effort from a major manufacturer to be more transparent about the cost of drugs. We’d love to see a truly comprehensive report, something (i) that goes beyond a position statement (as Novo Nordisk recently put out – though this was a great step) to really shed light on some of the areas clouding the process of how a drug is priced; and (ii) that suggests feasible, actionable next steps to address the pricing problem. Ultimately, this is an interesting announcement, and we hope it produces an objective, candid representation of pricing within J&J’s pharmaceutical business where something is actually learned. The dominant narrative we’ve heard so far diverts attention to how the industry promotes innovation – this was particularly pronounced at the 2017 JPM Healthcare Conference earlier this month. While industry is certainly invaluable in driving life-saving biomedical innovation, this narrative has done little to quell rising public and political fervor over drug prices – we also believe so little is understood about PBMs and what value they are adding and we’d love to see some changes here. Overall, we’re glad to see J&J join the ranks of pharmaceutical companies taking somewhat concrete steps to address drug pricing – we’ve also been impressed by Lilly’s discount insulin program, Novo Nordisk’s commitment to capping list price increases in the single digits, and Sanofi’s pricing strategy for basal/GLP-1 combo Soliqua (insulin glargine/lixisenatide).

Management responded to many questions on competitive drug pricing by emphasizing two points: (i) J&J invests more in R&D than in sales/marketing, and (ii) the $9 billion invested in R&D for the full year 2016 was more than what the business brought in through net US price increases. We appreciate this clarity and on a separate front, a question that immediately came to mind was how much of the $9 billion was allocated to diabetes research. We also wonder the degree to which there is waste across the $9 billion and what could be achieved by more efficient approaches to R&D. While management pinpointed Invokana and bariatric surgery as bright spots for J&J’s company-wide diabetes portfolio, we hope that investments are being made to advance these therapies and innovate further (in a prediabetes CVOT, among other clinical projects surrounding canagliflozin). See our pipeline summary table below for updates on the diabetes-related Janssen projects that we’re aware of, including those not mentioned on the call.

Fresh off a meeting with President Trump (which took place yesterday), Mr. Gorsky outlined four key components that J&J management hopes to see in new healthcare legislation to replace the Affordable Care Act (ACA): (i) retained elements from the ACA including coverage of preexisting conditions and coverage for young people on their parents’ plans (there was zero clarity on what would fund this); (ii) supports for a competitive market health insurance marketplace; (iii) a move toward value-based care and reimbursement; and (iv) reforms that prioritize preventative care and wellness. He underscored, however, that it’s too soon to speculate as to what new American healthcare policy will look like. The company experienced no uptick in business – pharmaceutical or otherwise – upon implementation of the ACA, according to Mr. Gorsky, so he expressed no concern about the negative consequences of its repeal. On the other hand, we’re extremely worried about the ACA’s total repeal from the patient perspective – a period of turmoil in healthcare policy could leave many patients without access to essential therapies, and we’re firmly of the opinion that amending the ACA is a better solution than dismantling it completely. It was disappointing to hear such a “patient-centered” company such as J&J be so blithe about the ACA; we recognize, of course, that the ACA during the Obama administration was in big need of further work. Few policies are perfect in their first iteration, and President Trump’s administration has the opportunity to improve the nation’s health insurance landscape. Realistically, though, total repeal seems like a very real possibility. We wait, with many questions…